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Gold as an Investment

Why invest in gold?

Excerpted from A Guide to Investing in Gold by the World Gold Council

The reasons for investing in gold have remained much the same over history:

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Long-term Store of Value

Gold has acted as a reliable "store of value" because it fulfills the functions of money:

  • It is portable and divisible. Its weight is a good measurement of a unit of value.
  • It is indestructible, relatively scarce, and cannot be "manufactured".
  • It is easily recognizable and acceptable as a form of payment.

Through both hard times and times of plenty, gold endures. Market cycles are permanent facts of life but gold has maintained its long-term value. In contrast, most currencies (including the U.S. dollar) and industrial commodities have generally declined. This is why gold is so often purchased as a hedge against inflation and currency fluctuations. And why so many investors around the world see gold as the "ultimate asset" - an important and secure part of their investment portfolio.

In other words, the value of gold - what it can buy in real goods and services - has remained remarkably stable over time. For example, a man's suit in sixteenth century England at the time of King Henry VIII cost the equivalent of one ounce of gold, roughly the same as a suit would cost today.

Asset of Last Resort

Gold is known as the "asset of last resort". Throughout history, national currencies have come and gone but gold has remained remarkably stable. Gold is an asset which does not depend upon any government's or corporation's promise to repay. It is not directly affected by the economic policies of any individual country and it cannot be repudiated or frozen as in the case of paper assets. For these reasons, one quarter of all the gold in existence is held by governments, central banks and other official institutions as part of their international monetary reserves. There is nothing to suggest that gold's reliability as a long-term store of value will change in the future, despite there being from time to time a more attractive "money" safe haven such as the U.S. dollar, for example, or the Swiss Franc.

Highly Liquid

Gold is among the most liquid of the world's assets. It can be readily sold 24-hours a day in one or more markets around the world. This cannot be said of most investments, including stocks of the world's largest corporations. In addition, the trading spreads on bullion are comparable to those on stocks and bonds (which are considered to be liquid assets). Finally, it takes about the same amount of time to execute a trade in gold as it does for stocks and bonds.

Asset Diversifier

Whether your investment approach is conservative or aggressive, gold can play a vital role in diversifying your portfolio. For this reason, many experts urge investors to keep a portion of their total assets in gold. Since most portfolios are invested primarily in traditional financial assets such as stocks and bonds, adding gold to a portfolio introduces an entirely different asset. The purpose of diversification is to protect the total portfolio against fluctuations in the value of any one asset class. Gold does exactly that.

Gold's ability to serve as a diversifier is due to its low-to-negative correlation with stocks and bonds. The economic forces that determine the price of gold are different from, and in many cases opposed to, the forces which determine the prices of most financial assets. For example, the price of a stock depends on the earnings and growth potential of the company it represents. Likewise, the price of a bond depends on its safety, its yield, and the yields of competing fixed income investments. The price of gold, however depends on different factors including the supply and demand for gold, the status of the U.S. dollar, the state of inflation and interest rates. While the effect of these factors on the gold price are somewhat complex, the important point to remember is that they cause the price of gold to move independently of the prices of other assets in a portfolio.

Gold is the only asset that is negatively correlated with other asset classes as demonstrated in the chart above. Therefore, its price generally moves in the opposite direction from other asset classes such as U.S. stocks, Treasury bills, and bonds.

Due to its negative correlation to other asset classes, gold can reduce portfolio volatility or risk. the chart above illustrates how a negatively-correlated asset (like gold) can lower portfolio volatility or risk. In this example, a new asset is added to a portfolio with a risk level of 10% (as measured by standard deviation) to amount for 10% of its total value.

The more negative the correlation between the new asset and the pre-existing portfolio, the lower the overall level of volatility will be for the new portfolio. For example, if the new asset is perfectly correlated with the pre-existing portfolio (that is, the correlation is 100), then adding any amount of the new asset will not change the level of portfolio risk. However, if the new asset has a correlation of less than 100, (say 50), it reduces portfolio risk slightly to a level of 9.6%. If the new asset has a correlation of 0, then the portfolio's risk is reduced modestly to a level of 9.2%. Finally, if the correlation of the new asset has a correlation of -50 (similar to gold's correlation with U.S. equities), then portfolio risk is reduced significantly, to a level of 8.8%.

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